In recent years, the uptake for M&A representations and warranties insurance has increased. Just the same, even now, the participants in the M&A transaction often do not always fully understand what they need to know about the insurance. In particular, some transaction parties don’t always appreciate why they need reps and warranties insurance protection.

A July 31, 2013 article from the Kirkland & Ellis law firm entitled “Why You Need M&A Reps and Warranties Insurance” (here) details the reasons why the insurance product should be of interest to both buyers and sellers in the M&A context. As the article notes, the insurance can “increase deal value and may make the difference between whether or not a deal gets done.”

As the article explains, the insurance product is available either for the buyers (a buy-side policy) and the sellers (a sell-side policy) in an M&A transaction. Both kinds of policies “can preserve deal value by shifting potential liability for unintentional and unknown breaches of representations and warranties” in the transaction documentation. The insurance may also be available “to cover certain general indemnities beyond the actual representations and warranties.” In exchange for an upfront payment, the policy “may reduce or eliminate the need for seller accruals, reserves or collateral for contingent liabilities” – an arrangement that could be particularly attractive in the current low interest rate environment.

According to the authors, the majority of the reps and warranties policies sold are buy-side policies. The buy-side policies allows a buyer “to recover directly from the insurer without making a claim against the seller,” which has the potential to reduce, or even eliminate, a buyer’s reliance on the seller’s funding or indemnification payments” for reps and warranties breaches. The way that the insurance facilitates payments reduces “collection risk where there are numerous sellers, foreign sellers or sellers at risk of insolvency.”

From the seller’s perspective, the insurance policies may allow a “clean exit,” by eliminating or reducing the need to establish purchase price escrows or holdbacks. Lower escrow or holdback amounts in turn allow the seller to distribute greater portions of the purchase price to investors while reducing the risk of a clawback. The availability of insurance coverage may also reduce a seller’s dependence on contributions from jointly liable co-indemnitors.

As the article discusses, the cost of the insurance can vary widely depending on the circumstances of the transaction. For most deals, the premium will be between two to three percent of each dollar of coverage, with the costs slightly higher for buy-side policies than for sell-side policies. Added up-front costs will include underwriting and due diligence fees as well as governmental taxes and fees (for example, for state surplus lines taxes).

The applicable retention generally ranges from “1 percent to 3 percent of enterprise value,” although it is “not uncommon” for the policy to provide for step-downs that decrease the retention if unused. The policy may also require that the retention is exclusive of any indemnification deductible or threshold so that “the insured has actual dollars at risk before it can recover on a claim” against the reps and warranties insurance policy.

In conclusion, the article notes, reps and warranties insurance “may allow parties to efficiently allocate risk and increase deal value. “ It may also be implemented to “strategically change the dynamics in a competitive process,” and may even “be determinative in whether a deal gets done.”